Where Are We in the Boom/Bust Liquidity Cycle?

Where Are We in the Boom/Bust Liq­uid­ity Cycle?

By Thomas Fahey, Asso­ciate Direc­tor of Macro Strate­gies, Loomis Sayles

March 2012

In an often cyn­i­cal world, stan­dard finan­cial and macro­eco­nomic quan­ti­ta­tive mod­els give peo­ple the benefit of the doubt. Fun­da­men­tal eco­nomic the­ory assumes the best of us, sup­pos­ing that human beings are per­fectly ratio­nal, know all the facts of a given sit­u­a­tion, under­stand the risks, and opti­mize our behav­ior and port­fo­lios accord­ingly. Real­ity, of course, is quite dif­fer­ent. While a sig­nificant por­tion of indi­vid­ual and mar­ket behav­ior can be mod­eled rea­son­ably well, the human emo­tions that drive cycles of fear and greed are not pre­dictable and can often defy his­tor­i­cal prece­dent. As a result, quan­ti­ta­tive mod­els some­times fail to antic­i­pate major macro­eco­nomic turn­ing points. The ongo­ing debt cri­sis in Europe is the most recent exam­ple of an extreme event shat­ter­ing his­tor­i­cal norms.

Once an extreme event occurs, stan­dard mod­els offer lim­ited insight as to how the ensu­ing cri­sis could play out and how it should be man­aged, which is why pol­icy responses can seem dis­jointed. The lat­est pol­icy responses to the Euro­pean cri­sis have been no excep­tion. To under­stand and respond to a cri­sis like the one in Europe, per­haps we need to con­sider some new mod­els that include the “human fac­tor.” Eco­nomic his­to­rian Charles Kindle­berger can offer some insight. In his book Manias, Pan­ics, and Crashes, Kindle­berger explores the anatomy of a typ­i­cal finan­cial cri­sis and pro­vides a frame­work that con­sid­ers the impact of the pow­er­ful human dynam­ics of fear and greed. Kindleberger’s descrip­tive process of the boom and bust liq­uid­ity cycle can help shed light on the cur­rent Euro­pean sov­er­eign debt saga, and per­haps illu­mi­nate whether we have in fact turned the cor­ner on this finan­cial crisis.

KINDLEBERGER AND THE MINSKY MODEL

Kindle­berger ana­lyzed hun­dreds of finan­cial crises dat­ing back cen­turies and found them to share a com­mon sequence of events, one that fol­lowed mon­e­tary the­o­rist Hyman Minsky’s model of the insta­bil­ity of a credit sys­tem. Fun­da­men­tally, the more sta­ble and pros­per­ous an eco­nomic struc­ture appears, the more lever­age and spec­u­la­tive financ­ing will build within the sys­tem, even­tu­ally mak­ing it highly vul­ner­a­ble to a sur­pris­ing, extreme col­lapse. Kindle­berger pro­vided the qual­i­ta­tive (as opposed to quan­ti­ta­tive!) descrip­tion of the Min­sky Model, shown below, which is a use­ful snap­shot of the liq­uid­ity cycle. It can be applied to Europe and any poten­tial boom/bust can­di­date, includ­ing Chi­nese real estate, com­mod­ity prices, or investors’ recent love affair with emerg­ing mar­kets. Kindle­berger famously dubbed this sequence a “hardy peren­nial,” prob­a­bly because the gal­va­niz­ing human con­di­tions of fear and greed are more often than not prone to over­shoot fun­da­men­tal val­ues com­pared to the behav­ior of a ratio­nal indi­vid­ual, which exists only in macro­eco­nomic theory.

DISPLACEMENT

The boom typ­i­cally starts with a “dis­place­ment,” a macro­eco­nomic shock (for exam­ple a new tech­nol­ogy, dereg­u­la­tion of an indus­try), that cre­ates new profit oppor­tu­ni­ties. For Europe, dis­place­ment came in the form of the Eco­nomic and Mon­e­tary Union (EMU) in 1999, which united par­tic­i­pat­ing coun­tries under a sin­gle mon­e­tary pol­icy and cur­rency, the euro. By estab­lish­ing one inter­est rate for EU mem­ber states, EMU enabled all par­tic­i­pat­ing sov­er­eigns to trade as if they pos­sessed Germany’s supe­rior cred­it­wor­thi­ness, regard­less of their fiscal con­di­tion. The oblig­ing mar­ket responded by lend­ing to EU coun­tries indiscriminately. (more)